The capitalization rate, cap rate, is to income property what earnings yield is to stocks. It answers one question: as a pure building, what annual return does this property produce on its price? The formula is a division: NOI ÷ value × 100.
Why financing is excluded
Imagine two buyers approach the same $1,000,000 building. One pays all cash; the other borrows 70%. If mortgage payments were part of cap rate, the same building would show two different 'cap rates', and the metric would measure the buyers' banks instead of the building. Excluding debt makes cap rate a property metric: NOI is divided by the whole price, so financing simply never enters.
Reading a cap rate
A 5% cap rate means the property's income equals 5% of its value each year, before financing. Lower cap rates usually accompany properties perceived as safer, newer, or in stronger locations, investors accept less income per dollar of price. Higher cap rates suggest more risk, more management burden, or weaker growth prospects. There is no universal 'good' number: the honest comparison is against similar properties in the same market.
The reverse trick: pricing from income
Cap rates work in both directions. If comparable buildings trade around a 6% cap rate, a building producing $60,000 of NOI implies a value near $1,000,000 (60,000 ÷ 0.06). This 'income approach' is standard practice in commercial valuation, and a useful sanity check for any listing you analyze.
What cap rate does not tell you
- Your personal return, that depends on leverage (see cash-on-cash return).
- How the loan amortizes or the rate behaves.
- Future rent growth or expenses, cap rate is a snapshot, not a forecast.
Run your own numbers in the cap rate calculator, which builds EGI from vacancy first, the professional way.